NEW YORK, Oct 3 (Reuters) - U.S. stocks dropped on Thursday as investors worried that a budget stalemate in Congress would become entangled with much more critical legislation to raise the federal borrowing limit.

The standoff between congressional Democrats and Republicans to pass an emergency funding bill, which has led to a third day of a partial U.S. government shutdown, continued with little sign of progress toward a solution.

Stocks trimmed losses after the New York Times reported that House Speaker John Boehner told colleagues that he would not let the United States default on its debt.

Boehner’s spokesman said the speaker had always said that the United States will not default on its debt.

“The fact is that every day we are looming closer and closer to the debt ceiling issue, which is the real concern,” said Randy Frederick, managing director of active trading and derivatives at Charles Schwab Corp in Austin, Texas.

“While market losses haven’t been too big during shutdowns, we did retreat about 17 percent in the summer of 2011 just before raising the debt ceiling.”

The CBOE Volatility Index VIX, often used to measure investor anxiety, jumped as high as 18.71, its highest level since late June. The VIX rose 160 percent to 42.96 in the third quarter of 2011 as the S&P 500 index fell 14 percent, the biggest retreat since 2008.

The Treasury has said the United States will exhaust its borrowing authority no later than Oct. 17. If no deal is reached on raising the debt ceiling, the United States could default on its debt.

Earlier in the day, President Barack Obama challenged Republicans to “stop this farce” by allowing a straight vote on a spending bill.

The Dow Jones industrial average was down 136.66 points, or 0.90 percent, at 14,996.48. The Standard & Poor’s 500 Index was down 15.21 points, or 0.90 percent, at 1,678.66. The Nasdaq Composite Index was down 40.68 points, or 1.07 percent, at 3,774.34. The S&P 500’s 50-day moving average stood at 1,679.84.

The S&P 500 has dropped in nine of the past 11 sessions. Among sectors, utilities and industrial names were among the hardest hit, down 1.2 percent and down 1.1 percent, respectively.

U.S. stocks briefly extended losses in late afternoon after shots were fired outside the U.S. Capitol but quickly recovered. The S&P 500 index closed below its 50-day moving average, often viewed as a technical level to sell shares.

The Capitol was locked down briefly after the shots were fired. The House and Senate were in session at the time.

In economic news, the Institute for Supply Management said its services index fell to 54.4 last month after nearing an eight-year high in August.

Tesla Motors Co shares fell 4.2 percent to $173.31 after an automotive blog published images of a Model S electric sedan in flames after an accident.

Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said the partial shutdown of the U.S. government will hurt growth in the last quarter of this year and the Fed’s decision not to taper its bond buying stimulus of the economy was vindicated by the fiscal impasse.

Trading volume totaled about 6.1 billion shares on the New York Stock Exchange, the Nasdaq and the NYSE MKT, below the average daily closing volume of about 6.3 billion this year.

Declining stocks outnumbered advancing stocks by about 4 to 1 on the New York Stock Exchange while on the Nasdaq, decliners beat advancers by about 3 to 1.